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Here's Where to Find the Explosive Returns

You have to look for special situations.

Many investors take it as an absolute truth that high returns necessitate high risk -- but it simply isn't so.

The whole premise of value investing is mispricing -- and the resounding success of legendary value investors such as Ben Graham, Warren Buffett, and Joel Greenblatt has shown that the market is often irrational, leaving gaping-wide opportunities for us to score massive gains without a commensurate level of risk.

A master of such investing, Joel Greenblatt achieved a gross annual return of some 50% in his Gotham Capital fund over a decade. Said another way, he generated a cumulative return of 5,200% compared with a 154% return for the S&P 500. Amazing.

How did he find the buried treasure?One of Greenblatt's trademark strategies was looking to "special situations" -- like mergers and spinoffs -- for mispriced stocks with superior return potential. According to a study by Lehman Brothers, 88% of spinoffs between 2000 and 2005 outperformed the S&P by an average of 45% in their first two years as stand-alone businesses.

Why are spinoffs so successful?

The two businesses were unrelated. Often conglomerates are priced less than the stand-alone value of the individual businesses they comprise, so a spinoff offers the market the opportunity to more accurately price the businesses.

Poorly performing businesses may be separated from a parent. Without the albatross of a money-losing business around its neck, a solidly profitable parent company can become more attractive to investors, raising its stock price.

A hard-to-sell business can be spun to shareholders. An unattractive but fundamentally sound business might be hard to sell. In addition, the parent might load the spinoff with debt, improving the parent's financials in the process.

Even though spinoffs are successful, they tend to be mispriced because their shareholders don't want their shares. Their primary shareholders tend to be individual and institutional investors in the parent company, who usually receive a limited number of shares in the spin-off. Because their interest was primarily in the parent company (and because structural realities like size prevent institutional investors from keeping shares), they often sell the spinoff regardless of value.

Because such inefficiencies are built into the system, spinoffs continue to offer fertile ground for those looking for buried treasure.

A case studyHere are just a few high-profile spinoffs from the last 15 years.

Parent

Spinoff

Spinoff's Return

Date of Spinoff

PepsiCo(NYSE: PEP)

Yum! Brands

405%

September 1997

Altria(NYSE: MO)

Kraft(NYSE: KFT)

22%

June 2001

Sara Lee

Coach(NYSE: COH)

1,389%

October 2000

Cablevision

Madison Square Garden

(8%)

January 2010

Source: Yahoo! Finance, as of Feb. 16, 2010.

Although spin-offs of large companies like these can be profitable, you're much more likely to find explosive returns in spinoffs of little-understood small caps, especially if they come from a huge parent such as a Bank of America(NYSE: BAC), Microsoft(Nasdaq: MSFT), or Citigroup(NYSE: C).

The importance of small-cap spinoffs is illustrated by one of Greenblatt's biggest successes: Marriott.

To optimize its operations, Marriott had decided to split itself into two separate businesses: Host Marriott, to own its properties, and Marriott International, to manage those properties. The second business was highly desirable because of its lucrative and asset-light management business. The first business was the ugly stepchild -- it owned low-growth properties and was loaded with billions in debt before it was set free. Which of these companies was the value?

After some due diligence, Greenblatt decided to invest in Host Marriott. He was particularly keen on the supposed unattractiveness of the business, the fact that key insiders in Host were incentivized to make the company succeed, and that Host was highly leveraged, since debt would magnify returns if the company were successful.

Within four months of being spun off, Host Marriott ended up nearly tripling.

Come dig with usWhile some lucrative spinoffs are high-profile, there are many more under-the-radar stocks that offer even better opportunities. Finding the value hidden in such special situations is the task Tom Jacobs, advisor at the newly formed Motley Fool Special Opportunities, has taken on. He's beaten the S&P by an average 10% for seven straight years, with a total return of 188% in that period versus just 46% for the S&P.

If special situations and deep value opportunities intrigue you, then let Tom Jacobs at Motley Fool Special Opportunities take your investing to the next level in 2010. Membership is strictly limited, so enter your email in the box below to receive your invitation!

Jim Royal, Ph.D., owns shares in Bank of America and Microsoft. Microsoft is a Motley Fool Inside Value pick. Coach is a Stock Advisor recommendation. PepsiCo is an Income Investor pick. Motley Fool Options has recommended a diagonal call position on Microsoft. The Fool has adisclosure policy.